Finding Liquidity in the Cosmos
The majority of cryptocurrencies are volatile assets whose prices fluctuate for a number of reasons. Traders will want to swap these assets for stablecoins or even other volatile assets.
As many of you will know, access to high-quality decentralized exchanges is critical for Nolus Protocol. Depositors on Nolus Protocol provide stablecoins to pools which are subsequently swapped for the asset that a borrower desires (through Interchain Accounts).
Making efficient trades is important as it allows a finite pool of stablecoins to provide more loans to borrowers.
The cost of a swap on a decentralized exchange consists of a number of elements:
- The rate for a swap (which is determined by the model of the DEX and its underlying liquidity);
- Fees that accrue to Liquidity Providers (also including the Governance Token stakers); and
- Transaction Fees for the swap.
Within the Cosmos ecosystem, the first two elements are the most important as transaction fees on appchains are immaterial. However, in environments with higher gas costs, such as Ethereum, transaction fees have been a determining factor for the exchange a swap is conducted on.
Below, we discuss what the issues with legacy models are and how the Cosmos ecosystem is evolving towards more efficient models!
Difficulties Trading With Volatile Assets
The majority of cryptocurrencies are volatile assets whose prices fluctuate for a number of reasons. Traders will want to swap these assets for stablecoins or even other volatile assets.
The earliest implementations of decentralized exchanges were AMMs which used a curve with the simplified equation of X * Y = K, where X and Y are the reserves of each asset and K is a constant. The curve is plotted below for reference.
This model has been used by most legacy Cosmos ecosystem DEXes. It is the model used by most Osmosis pools and has been used by JunoSwap and SiennaSwap among others.
This model evenly distributes liquidity across all price ranges (with prices approaching infinity on both sides of the spectrum) which means an asset can always be traded with its liquidity pair.
However, this model is not suitable for large trades (relative to the size of the liquidity pool). While the even distribution of liquidity has benefits, it means that the majority of liquidity in a pool is not utilized which makes traders incur high slippage on large trades.
Concentrated Liquidity
The concentrated liquidity model was made popular by UniSwap with their UniSwap v3 implementation. This model allows liquidity providers to deploy liquidity within a specific price range.
Liquidity providers are incentivized to concentrate their liquidity around the market price to earn the most fees. This makes these DEXes significantly more efficient and less dependent on TVL. When UniSwap v3 launched, it was suggested that these new liquidity pools could be 4000x more efficient than their predecessors.
Fortunately for the Cosmos ecosystem, there are many teams working on implementing this more efficient model. Joining Crescent DEX, Osmosis, and Astroport are both gaining inspiration from their counterparts in Ethereum (in Osmosis and Curve) to implement this model in slightly different ways!
Order Books
Centralized exchanges have long offered order books to traders. It allows traders to match their orders with one another on a “price-time-priority-basis.”
In short, the highest bid and the lowest ask converge to represent the current market price, and users have the option to cross this bid-ask spread to execute the order immediately.
Similar to concentrated liquidity, the order book model results in liquidity providers concentrating their liquidity around the market price which results in higher depth for trades (lower slippage).
Order books also have a number of additional benefits:
- Allow traders to place limit orders, bids, and offers; and
- Allow liquidity providers to provide liquidity to a single side at their desired price.
The Cosmos ecosystem has two notable order books in Kujira’s Fin and Injective Protocol’s Helix. While they are still in their infancy, their ability to attract volume demonstrates the value of an order book for efficient trades.
Furthermore, exchanges such as Crescent DEX have taken this a step further to enable a liquidity pool in their AMM to act as a market participant within the accompanying order book. This allows liquidity providers who wish to provide liquidity on both sides of a pair to continue to do so and further amplifies capital efficiency to provide more depth (and lower slippage) to traders.
Closing Remarks
While DeFi in the Cosmos ecosystem is still in its early years, teams have begun to take huge leaps and strides into making DeFi much more efficient which has been demonstrated with improvements in trading.
With current teams improving day by day and many new teams currently developing their models, we expect to see this be highly beneficial for depositors on Nolus Protocol who will see their yield grow over time!
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